This research paper explores the accounting fraud done in the corporate world by utilizing the examples of the companies who did the accounting fraud. We propose that the accounting methods used for producing the financial statement provides an opportunity and vehicle for corporate companies to commit accounting fraud. The work also focuses on the role of the Securities and Exchange Commission (SEC) for the scandals. We used the sample companies for which the SEC has documented accounting fraud in their enforcement releases. We analyze the different aspects like how the fraud was discovered, what were there effects on the corporate world, role of internal auditor and auditor, related actions of SEC to determine the penalty.
These findings provide a brief insight review of main unprofessional behaviour of accountancy professional who were responsible for each action in scandals and show how accountants move from watchdogs to architects of clever deals and frauds as CFO's and CEO's and how company management fails to their responsibility to give fair and true view of the company to public.
Keywords: accounting fraud, corporate, auditing
Review of Relevant Literature.
In a 1996 study, Gramling et al. made a survey which addresses the issues such as appropriate role of auditors and the role of specific parties to whom audit to be done. The issues addressed in their study include: the appropriate role for auditors, role of corporate to whom this auditors are responsible .It also discusses the prohibitions and regulations that should be placed on audit firms; and the decisions that auditors would likely make in a series of specific case studies. The research conducted focused on one or two expectation gap issues and only from the perspective of one of the relevant parties.(The expectation gap is defined as the gap between public and financial statement users believe auditors are responsible for and what auditors themselves believe their responsibilities are)
(http://www.cluteinstitute-onlinejournals.com/PDFs/200470.pdf)
Methodology:
The paper used the historical events of scam of three different companies and evaluates how accounting professional used the Gap system of accounting to their benefits.
The method of analysis will include the series of valid questionnaire. Which will be answered by various details available related to the scam.
WorldCom: The history of manipulating Accounts
Introduction:
The story of the WorldCom begins at the coffee shop of the Hattiesburg, MS. A former basketball coach Bernard Ebbers while having a coffee wondered an idea for a long distance company on a napkin. He set up a company name LDDS (Long Distance Discount Services) in 1984 which provides services like long distance reseller. The Company started to grew quickly in a very short journey of 15 years and became one of the largest telecom provider of United States. The company went public in August 1989 and he became the richest person of the United States. The company shares of the WorldCom reached at the peak level of $64.51 but after that stock of the company started to fall as WorldCom failed to purchase Sprint in 2000 because of the antitrust law but it succeeded to purchase MCI in 1997 for $37 billion. In 2001 they owned a third of the US data cables and in 1998 and 2002 it was second largest long-distance operator in United States with more than 20 million customers.
What was the fraud about?
The fraud begin when the Scott Suvillan a CFO, Treasurer and Secretary of the WorldCom instructed accounting staff to record the false entries. In addition to this he also posted false entries himself and misrepresented investors and others by showing growth in critical time.
From 1998 WorldCom started to reduced reserve accounts which were held to cover liabilities of (http://www.worldcomnews.com/worldcomhistory.html) acquired companies, WorldCom added $2.8 million to revenue line from these reserves but reserves didn't cut this revenue. They just informed to one of division at Texas by just sending e-mail showing expenses which was recorded improperly. Scott Suvillan directed key staff members of the accounting department to mark operating costs as long term investments amount of $3.85 billion. It also included computer expenses worth of $ 500 million which was recorded as a computer assets.
By the result of all these fictitious entries company's huge loss turned into significant profit of $1.38 billion which inflated company's value in its assets.
How fraud was discovered?
MCI audited and reviewed uncovered accounting irregularities with the help of internal auditors.
In march 2002, John Stupeka complained to Internal audit about $400 million which was set aside by him and Sullivan wanted to use this money to boost WorldCom's income
At the same time SEC requested information about the financial datas from the WorldCom because at that time AT&T was incurring loss and WorldCom showed huge profit in their book.
Internal auditors started scrutinizing the suspected entries and transactions and they found $ 2 billion unauthorized capital expenditure, out of which $ 500 million was computer expense but recorded as a computer asset also Mr. Morse ,internal auditor found $ 2 billion of the suspected entries in the company computers.
In June 2002, Internal auditor contacted audit committee of the company for the documents which supports the various capital expenditure, but they didn't forsound any document supporting those entries.
The financial controller of the company supported the internal auditor by stating that accounting standards were not followed while recording entries in the books of the company.
June 20, 2002 - Internal audit explains irregularities to the Audit committee.
June 25, 2002 - WorldCom announces inflated profits by $3.8 billion over the previous five quarters.
June 26, 2002 - civil suit was filed and stock trading was halted. Ultimately, stock was delisted by NASDAQ.
July 21, 2002 - WorldCom filed for bankruptcy ( www.aicpa.org/download/antifraud/121.ppt)
What was the effect of the fraud on market?
Effect on the investors:
Nearly 67 institutional investors recovered $651 million on price of losing $1.8 billion from a group of banks and other defendants to compensate the investors for losses on purchases of WorldCom bonds and stock.
As usual this time also shareholders of the company suffered a lot. They even were not able to get the dividend declared by the company of $ 0.60 to save $ 71million.Shareholders were having the option of sending back their current shares in to exchange for new shares in reorganized company. But, here company was declared insolvent so shares were considered Worthless. Finally, company got agreed to pay $ 0.56 per share which was nothing against its value. In addition to this WorldCom got delisted from the NASDAQ stock market.
As WorldCom filled chapter 11 bankruptcy, the bondholders of the company cannot expect to receive interest as well as principal payments. But, company got agreed that they will give $426.66 for every $1000 and also Bondholders may have chance to receive new stock in exchange for bonds.
Effect on the corporate world:
The effect of the WorldCom scandals experienced by the market soon after WorldCom declared bankruptcy. The effect was not limited to the United States but in countries like Japan and U.K. also stocks of telecom and technology were affected negatively. Many well-known banks of U.S. and other European countries were affected negatively because they were direct investors in the WorldCom. WorldCom also announced that they are going to lay off their 17,000 employees to save $ 900 million annually; this was negative news for the market. (http://www.cfo.com/article.cfm/5100871?f=related)
What was the role of the auditor?
The Securities and Exchange Commission declared Kenneth M.Avery and Melvin Dick (Former auditors of the WorldCom Arthur Anderson audit partners) as unprofessional and criticize there work. As auditors of WorldCom for 2001.
SEC concluded that the Auditor were aware about the improper entries by the CFO and the top level executives of the company. Auditors relied on the management's presentation instead of documentary evidence. They were aware of huge personal debt owed by the CEO of WorldCom Bernard Ebbers. They failed to state whether the financial statement is free from material misstatement and the present financial statement of WorldCom according to the GAAP.
What was the role of Internal Auditor?
The role of the internal auditor in this case was admirable. Cynthia Cooper, head of internal audit department played good role to uncover the fraud. While performing financial audit Ms. Cooper found unauthorized $2 billion which company declared as a capital expenditure during the three quarters of 2001. Ms. Cooper set meeting with audit committee of the WorldCom and show the complete picture of fraud. Audit committee immediately fired Mr. Suvillan, CFO of the WorldCom and accepts the resignation from the Mr. Myres, vice president and controller of the WorldCom who helped the CFO to record false entries. They announced that WorldCom's profit was inflated by $3.8 billion over five previous quarters and then they file for the bankruptcy.5
(http://www.webcpa.com/news/27412-1.html)
What were the major issues?
The major accounting issues were of maintaining irregularities in accounting entries. Management of the company directed staff members to record various false entries like improper transfer to revenue line from reserves, unauthorized huge capital expenditures and recording the capital expenditures as a long term capital assets.
The major auditing issues were that the auditors even though being aware of the false entries in the financial statements by the management they didn't consider those aspects while presenting the audit report and also didn't ask the management to present evidence of the huge expense incurred.
What were the actions by the SEC and Court?
Ten former directors agreed to pay $ 54 million to settle shareholders' lawsuit. Out of $54 million, $18 million came from the pocket of the directors and rest from the liability insurance. CEO Ebbers and former CFO Sullivan were charged with fraud and violating securities laws. Ebbers found guilty on the all counts and sentenced to 25 years imprisonment, but free for appeal. Suvllivan was pleaded guilty and took the stand against Ebbers, in exchange for a more permissive sentence of 5 years. WorldCom renamed with MCI, subsequently, the U.S. District court ordered WorldCom to pay $500 million in cash and transferring $250 million worth of common stock in the reorganized company when it emerges from bankruptcy into a fund for later distribution to victims of the company's fraud as per the SEC's penalty.
Introduction
Enron Corp. shaped in 1985 from a merger of Houston Natural Gas and Internorth. Enron was first nationwide natural gas pipeline network. It became largest global energy, service and Commodities Company. As government deregulated the natural gas industry in the late 1980's and electricity industry in 1990's, Enron became $100 billion dollar company. At the time of merger Kenneth lay became the top executive of Enron and he hired Jeffery Skilling as one of his top subordinates. They started to sell electricity in 1994 and entered European energy market in 1995 and dominate the trading of energy contracts and financial instruments known as derivatives. Nearly quarter of energy contracts of the world were dominated by Enron in late 1990's. In 1999 Enron launch web-trading site enrononline.com to trade electricity online which made Enron the largest e-commerce company by reaching trade worth of $335 billion in 2000. The external Auditor of the Enron was Arthur Andersen.
What was the fraud about?
As compare to WorldCom there were more issues in the Enron like Internal Control Issues, Financial issues, Accounting and Auditing issues, corporate governance issues, pension issues. Here is discussion for the major issues of the company.
Enron adapted the latter treatment "off-balance sheet" which was helpful to present Enron more attractive as measured by the ratios favored by Wall Street analysts and rating agencies.
Enron engaged in hundreds of special purpose entities or SPEs to present impressive profits each year. Generally organized as limited partnerships, SPEs can take many legal forms. The primary motive of SPEs is to finance a construction project or purchase the asset. SPEs act as a debt avoidance instrument for large corporations to raise large finances for various purposes. SEC and FASB provided little insight in accounting and reporting of SPEs to accountants.
The 3% rule is the most important guideline implemented for SPEs by authoritative bodies. This means that if the external parties, independent of the company invests 3% of the total capital in SPEs, then the assets and liabilities of SPEs do not appear on the consolidated financial statements of the company. This made the companies to arrange exactly 3% capital from SPEs and the remaining 97% were financed by external loans generally collateralized by the company that created SPEs.
Besides financing, Enron also used SPEs for selling non profitable assets to SPEs. This was how Enron removed the loss making assets from its consolidated financial statements. SPEs can finance the purchase of those assets by loans collateralized by Enron's common stocks. Enron grossly inflated the prices of assets sold to SPEs in order to gain large 'paper profits'. Sometimes Enron protected the nominal owners from any losses and also guaranteed them an extra profit by making undisclosed side agreements with them.
The disclosures provided by Enron regarding SPEs were limited and very confusing. These inadequate disclosures provide no information to nonprofessional investors. The impressive profits of Enron were as unreliable as these disclosures. According to Sherron Watkins' letter to Kenneth Lay in August 2001, the large and complex transactions between Enron and SPEs effectively allowed Enron to report unrealized gains on the increase in the market value of its own common stock. In a way Enron was doing business with itself with the help of SPEs.
Enron created these SPEs primarily to finance the growing need of capital during 1990s. The transformation of Enron from a mere natural gas supplier to an intermediary for the energy industries constantly needed capital to finance the transformation. As the Internet-based operations did not earned adequate profits, Enron needed investor to invest money in the company. In order to raise capital, Enron's stock price should remain high and for that Enron needed a high rating from credit rating agencies. To get a high rating Enron window dressed its financial statements by creating SPEs to avoid debt on its balance sheet.
How was fraud discovered?
The primary reason of creation of SPEs was to finance its transition from energy supplier to energy trader. Around 97% investments in various SPEs were from loans made from external creditors. These loans were collateralized by Enron stock. So, they used to download the non-profitable assets from Enron's financial statements to SPEs' books. These assets are sold at higher prices than the book value creating higher paper gains for Enron to maintain the high prices of stock.
During 2001, because of Enron's lowering stock price, the additional investments were necessary to maintain the solvency of those SPEs. During the tenure of Andrew Fastow, CFO of Enron, he made $30 million dollar of profits on his investments. Even his friends and relatives earned enormous amounts of profits on their investments in those SPEs. Some of them made $1 million profit on their $5800 investment.
Enron started making large losses on SPEs due to the decreasing stock prices. Enron's management was forced to act by the Andersen auditors concerns for major losses. The company took over the full management of troubled SPEs. They also had to dissolve some of the troubled SPEs. This made Enron to show the assets, liabilities, profits and losses of SPEs in its consolidated financial statements. This resulted in the third quarter loss of $618 million. Also, because the assets sold by Enron were priced higher than book value, the owner's equity and assets were reduced by $1.2 billion.
Business journalists and Congressional investigative committees investigated the fraud created at Enron. Their findings became public in 2002. During these revelations about Enron, the public criticized Enron for its accounting manipulations and their use of SPEs. It also misused the mark-to-market accounting method for its long term contracts to deliver energy commodities. When the investigator and the press did not received satisfactory answers about the questionable accounting and financial reporting decisions, they focused their attention to their independent auditor, Andersen. People were shocked about the fact that Andersen expressed unqualified opinion in the last 15 years.
What was the effect of fraud on market?
Effect on the Employees:
Enron sponsored 401(k) retirement plan. For those employees to whom they can contribute a portion of their pay on a tax deferred basis. As on December 31, 2000, Total stock of Enron represented about 62% were from the 401(k) retirement plan. The shares of Enron were traded more than $90 in August 2000 was less than 70 cents in January 2002. By this plan employees of the Enron lost their huge savings of life nearly $850 millions.
(http://money.cnn.com/2001/11/26/401k/q_retire_enron_re/)
Effect on the Shareholders:
Shareholders received $7.2 billion in settlements under distribution plan approved in federal court. Approximately all eligibly common stock holders received $6.79 per shares and all Preferred stock holders received $168.50 per share. Eligible shareholders include shareholders who bought stocks of the company between September 9, 1997 and December 2, 2001.2
What was the role of Auditor?
The opinion of independent auditors on the financial statements of public companies is required by the federal securities law. Andersen was the external auditor of Enron. The responsibility of auditors is to provide objective point of view regarding the proper accounting and financial reporting decisions for those judgments. The Anderson representatives were criticized on a number of issues.
Andersen provided management consulting services to Enron. Providing management consulting and other services to public audit clients affected the independence and objectivity of the auditor.
Public reports that only $25 million were the audit fees out of $52 million received by Andersen. Andersen's Houston office received $1 million every week from Enron.
Andersen representatives were aware of the company's deteriorating financial condition since a long time. Andersen deeply involved in helping the company to cope with the
(http://www.chron.com/disp/story.mpl/special/enron/5991449.html)
Financial crisis. This also included the restructuring of some of the SPEs to maintain their solvency so that it can remain unconsolidated entities. The Power reports pointedly and repeatedly documented that Andersen's personnel were deeply involved in these transactions.
Andersen's Houston office was criticized for destroying significant and large quantities of Enron audits. In order to hide Andersen's role in collapse of Enron, Houston office shred undetermined number of significant documents relating to Enron and its finances.
What were the actions by SEC and Court?
Kenneth Lay, Jeffrey Skilling and Andrew Fastow were the center of all criticisms. Fastow admitted in 2004 that they created securities fraud at Enron. He was asked to sell his $25 million worth of assets accumulating during his term at Enron. SEC charged Kenneth Lay, former CEO for engaging in fraud and insider trading and misleading investors. He participated in various schemes with Skilling by falsifying financial statements to defraud investors. He sold $70 million of stocks during 2001 when the stock prices did not reflected true financial condition. He sold these stock back to Enron in repaying cash advances on an unsecured line of credit and sold $20 million stocks in open market. He was constantly making misleading statements in conference calls and meetings. Till the third quarter earnings release, he assured investors and credit rating agencies that company is in strong shape.
JPMorgan Chase, Citigroup and the Canadian Imperial Bank of Commerce collectively settled for $6.6 billion in 2005. Arthur Andersen, Bank of America and Lehman Brothers also gave small amounts. Former Enron directors collectively settled for $168 million. Other former Enron executives were settled for $30,000 to $2 million except for Lou Pai, Enron trader and retail energy division Chief Executive, who gave $31.5 million. Skilling agreed to pay $45 million criminal fine in 2006.
The FASB imposed stricter rules for the accounting treatment for SPEs. The more stringent guidelines for SEC to investigate have been implemented. Sarbanes Oxley Act was signed into legislation. Public Company Accounting Oversight Board was created to overview the auditing done by CPA firms. AICPA imposed restrictions on many services like tax services, management consulting services, book-keeping for public audit clients.
Xerox: The Photocopy of Fake Transaction
Introduction:
Xerox was founded in 1906 as the Haloid Company. It named Haloid Xerox in 1958 and Xerox Corporation in 1961. Xerox has emerged as a global document management company worth of $17.6 billion. Xerox provides the document industry's broadest portfolio of offerings. Digital systems include color and black-and-white printing and publishing systems, digital presses and "book factories," multifunction devices, laser and solid ink network printers, copiers and fax machines. Xerox's services expertise is unmatched and includes helping businesses develop online document archives, analyzing how employees can most efficiently share documents and knowledge in the office, operating in-house print shops or mailrooms, and building Web-based processes for personalizing direct mail, invoices, brochures and more. Xerox also offers associated software, support and supplies such as toner, paper and ink.
What was the fraud about?
Xerox revealed in 2002 that it had overstated $6 billion in revenue leading to overstatement of earnings by nearly $2 billion for five years ending 2002. The announcement of Xerox was not entirely new. The SEC had charged the company with accounting manipulations. It was estimated that the amount involved was about $ 3 billion which was half of what was stated. Eventually they agreed to conduct a further audit and pay a $10 million fine. It was this audit that produced the $6 billion figure. Following is the selected financial data for Xerox from 1997 to 2000:
What they really did?
They used "cookie jar" method. Revenue was stored off the balance sheet and then released the funds at planned times to boost the deficit earnings for particular quarter. They classified the revenue from short-term equipment rentals as long term leases which accounted for larger part of fraudulent earnings. The difference was significant because, according to GAAP, they didn't include long term lease as revenue in the first year of agreement and didn't spread out the short term equipment rentals over the duration of the contract.
Because of the manipulation, future revenues were misstated as present earnings, boosting the profits to meet the profit expectations of 1997, 1998 and 1999. In 1998 the company, instead of loss of $13 million, reported a pre-tax income of $579 million. Then in 2001, after the reversal of manipulation, the $137 million loss becomes $365 million gain. Now the revenue reported less the accumulated profits of $1.9 billion will be added to future profits. Xerox spread out its income in fraudulent manner so Xerox has not been accused of falsely creating unearned income so that it boosts short-term profits.
How fraud was discovered?
The SEC commented that, if anyone was interested in looking at the manipulations, the fraud was easy to detect. Former SEC chief accountant Lynn Turner noted about the financial figures of Xerox that those numbers have got so big that it is difficult not to notice this. It is like driving past Mt. Everest and saying that they never saw it. The auditor of Xerox during this problematic term was KPMG, which is one of the big 4 accounting firms. It was replaced by PricewaterhouseCoopers (PwC).
KPMG was also part of the SEC investigation that began in 2001. During the investigation they obtained evidence that proved that the accounting firm allowed the fraudulent practices going on even when they knew about its existence. SEC obtained an internal document which had statement by KPMG official informing about fraudulent revenue recognition schemes of Xerox. When the auditor in charge raised questions about fraudulent techniques of Xerox, he was replaced with another auditor.
Civil charges were filed against top executives of Xerox and KPMG by SEC. KPMG was blamed for not doing the audit of Xerox properly and lawsuits were filed against them.
What were the major issues in this case?
Rresidual value of leased equipment was adjusted after the beginning of lease. This was in violation of GAAP. This adjustment was used to credit the cost of sales, which were used as gap closing measure to help to meet the expectations of Wall Street and investors.
They used reserves that were created for some other purpose to increase earnings which violated GAAP. It also used the gain from resolution of a dispute with the Internal Revenue Service to increase earnings from 1997 through 2000.
Xerox supposedly changed the way it accounted for lease revenue repeatedly but failed to disclose that the gains were not because of the improved performance but because of accounting changes which failed to comply with GAAP.
For calculating lease equipment valuation, Xerox used a return on equity allocation method which calculated the fair value of the equipment less estimated fair value of services as the portion of the lease payments. The equipment sales revenue increased as the fair value of services decreased.
Xerox also accelerated the recognition of revenues. It recognized revenue price increase of existing lease immediately instead of recognizing it over the life of lease.
Xerox didn't reveal factoring transactions which allowed it to hide year end negative cash balance. To realize instant cash flow, Xerox, sold its receivables at discount. Analysts expected stronger year end balances in 1999. Unable to meet expectations, Xerox made its largest operating units to engage in factoring transactions with local banks, affected Xerox's 1999 operating cash flows but was not disclosed in its 1999 financial statements. In some of the buy-back transaction, Xerox reacquired the receivables after the end of the year. They recorded these as sales and violated GAAP. They not only fail to disclose the agreements, but also failed to reverse them in the next year.
What were the actions by SEC and Court?
To settle the 8 year old securities lawsuit pending against Xerox and KPMG, Xerox agreed to pay $670 million while KPMG had to pay $80 million that was filed on behalf of Xerox investors. They claimed that accounting fraud was committed by Xerox to meet Wall Street earnings expectations.
In April of 2002, Xerox had already agreed to pay the largest ever fine paid by company to SEC, $10 million.( "Xerox." Analyz the World. 28 Dec 2007. www.analyzr.org, Web. 24 Feb 2010. <http://www.analyzr.org/tag//lease-accounting)
SEC alleged that the company's actions violated GAAP during the four year period by accelerating equipment revenue by more than $3 billion which increased its earnings before tax by approximately $1.5 billion. SEC alleged that the company used "accounting actions" and "accounting opportunities" trying to meet Wall Street expectations.
After it all cooled down, in 2005, KPMG agreed to refund $9,8 million back to Xerox along with $2.7 million interest for the fees received for audits from 1997 to 2000 and decided to pay 22.5 million SEC charges and $10 million civil penalty. This total package was the largest ever made by and audit firm to SEC.( "Xerox Accounting Scandal." Corporate Narc, Web. 24 Feb 2010. http://www.corporatenarc.com/xeroxscandal.php)
CEO, Barry D. Romeril and three others were charged with manipulation, planning, helping and approval of violating the reporting of books and records and not following federal securities law. [1] (http://www.ethicalcorp.com/content.asp?ContentID=683)
The six main defendants didn't admit or deny the SEC charges and agreed to pay over $22 million for paying back the profits that they gained because of the scam, penalties, and interest. The SEC intended that these funds to be ultimately distributed, after they are paid into the court, to the people who were the victims of the fraud.
Impact :Many changes taken place in the accounting industry .AICPA made several changes in SAS 96,SAS 98 and SAS 99.SAS 98 changes the relationship between GAAS and qualitycontrol standards ,audit risk and materiality concepts of audit.
SAS 99 outline the definition of fraud and reaffirms auditor's responsibility to search for fraud .The four major accounting companies break all ties with Andersen .Government reacted aggressively by introducing the Sarbanes-Oxley Act. According to which the companies needs to re-evaluate its internal audit procedures and make sure that everything is running up to the expectations. Accounting ethics were changed in the curriculums of accounting studies.
There was a new push to separate auditing services from consulting services.
Conclusion:
It can be concluded that the accounting professionals played a major role in the scandals. Though there is still confusion for the role of auditors and directors in carrying out these scandals. The management of the companies failed to give the public the confidence and exercise due care in planning, performing and evaluating the results of audit procedures and showing the professionalism. The accountancy professions have shown itself weak in technical matters, spineless in standing up to CEO's and eager to sacrifice its integrity for profits.
Executives of Enron, Xerox and WorldCom set out a negative impact on the accounting industry or any industry. They use the Gap in accounting system for making the quick money. This thoughtless acts and greed led both companies to an eventual downfall in bankruptcy .The accounting industry by making the responsible changes improve its standards and the economy too .One question always arrives that will the industry will ever be perfect? The answer is No.The accounting industry can give effective performance by continuously making the positive changes.
